Best of the Week
Most Popular
1.US Paving the Way for Massive First Strike on North Korea Nuclear and Missile Infrastructure - Nadeem_Walayat
2.Trump Reset: US War With China, North Korea Nuclear Flashpoint - Video - Nadeem_Walayat
3.Silver Junior Mining Stocks 2017 Q2 Fundamentals - Zeal_LLC
4.Soaring Inflation Plunges UK Economy Into Stagflation, Triggers Government Pay Cap Panic! - Nadeem_Walayat
5.The Bitcoin Blueprint To Your Financial Freedom - Sean Keyes
6.North Korea 'Begging for War', 'Enough is Enough', is a US Nuclear Strike Imminent? - Nadeem_Walayat
7.Bitcoin Hits All-Time High and Smashes Through $5,000 As Gold Shows Continued Strength - Jeff_Berwick
8.2017 is NOT "Just Another Year" for the Stock Market: Here's Why - EWI
9.Gold : The Anatomy of the Bottoming Process - Rambus_Chartology
10.Bitcoin Falls 20% as Mobius and Chinese Regulators Warn - GoldCore
Last 7 days
Boomers Are Not Saving Enough for Retirement, Neither Is the Government - 16th Oct 17
Stock Market Trading Dow Theory - 16th Oct 17
Stocks Slightly Higher as They Set New Record Highs - 16th Oct 17
Why is Big Data is so Important for Casino Player Acquisition and Retention - 16th Oct 17
How Investors Can Play The Bitcoin Boom - 16th Oct 17
Who Will Be the Next Fed Chief - And Why It Matters  - 16th Oct 17
Stock Market Only Minor Top Ahead - 16th Oct 17
Precious Metals Sector is on Major Buy Signal - 16th Oct 17
Really Bad Ideas - The Fed Should Have And Defend An Inflation Target - 16th Oct 17
The Bullish Chartology for Gold - 15th Oct 17
Wikileaks Mocking US Government Over Bitcoin Shows Why There Is No Stopping Bitcoin - 15th Oct 17
How to Wipe Out Puerto Rico's Debt Without Hurting Bondholders - 15th Oct 17
Gold And Silver – Think Prices Are Manipulated? Look In The Mirror! - 15th Oct 17
Q4 Pivot View for Stocks and Gold - 14th Oct 17
Gold Mining Stocks Q3’17 Preview - 14th Oct 17
U.S. Mint Gold Coin Sales and VIX Point To Increased Market Volatility and Higher Gold - 14th Oct 17
Yuan and Gold - 14th Oct 17
Tips for Avoiding a Debt Meltdown - 14th Oct 17
Bitcoin Hits New All-Time High Above $5,000 As Lagarde Concedes Defeat and Jamie Demon Shuts Up - 13th Oct 17
Golden Age for GOLD, Dark Age for the Stock Market - 13th Oct 17
The Struggle for Bolivia Is About to Begin - 13th Oct 17
3 Reasons to Take Your Invoicing Process Mobile - 13th Oct 17
What Happens When Amey Fells All of a Streets Trees (Sheffield Tree Fellings) - Video - 13th Oct 17
Stock Market Charts Show Smart Money And Dumb Money Are Moving In Opposite Directions—Here’s Why - 12th Oct 17
Your Pension Is a Lie: There’s $210 Trillion of Liabilities Our Government Can’t Fulfill - 12th Oct 17
Two Highly Recommended Books from Bob Prechter - 12th Oct 17
Turning Point Nations On The Stage - 11th Oct 17
The Profoundly Personal Impact Of The National Debt On Our Retirements - 11th Oct 17
Gold and Silver Report – Several Interesting Charts - 10th Oct 17
London House Prices Are Falling – Time to Buckle Up - 10th Oct 17
The S&P Is A Bloated Corpse - 10th Oct 17
Are Gold and the US Dollar Rallying Together? - 10th Oct 17
Is Silver Turning? - 9th Oct 17
Bitcoin Needs Electricity, Gold CONDUCTS Electricity - 9th Oct 17
S&P 500 At Record High But Will Stocks Continue Even Higher? - 9th Oct 17
Gold and Silver on Major Buy Signal, The Cycle is Up - 9th Oct 17
How To Fight Corruption in the Philippines - 9th Oct 17
Stock Market Bulls Still in Charge - 9th Oct 17
DiEM25: Europe Without Nations or Religion - 9th Oct 17
Gold Price Readying to Rally - 8th Oct 17
Gold Price in Q3 2017 - 8th Oct 17
PassMark Bench Mark of OVERCLOCKERS UK Custom Built Gaming PC (5) - 8th Oct 17

Market Oracle FREE Newsletter

3 Videos + 8 Charts = Opportunities You Need to See - Free

Bullish, But Nervous? Here's how to protect your Stock Profits - and make more...

Portfolio / Options & Warrants Dec 30, 2010 - 05:53 AM GMT

By: Money_Morning

Portfolio

Best Financial Markets Analysis ArticleBy Larry D. Spears writes: Since bottoming out in early July, the stock market has turned in a brilliant performance, giving many investors Christmas stockings bulging with profits. However, it also has left a lot of investors nervous - though not the ones that know how to use options.


Will a strong January Effect extend the market advance, which has seen the Standard & Poor's 500 Index climb 22.97% from its July 2 low of 1022.58?

Or, will further downgrades of European debt, high unemployment, a dismal housing market and other negative factors finally stall the rally?

Although many analysts are offering projections, no one can say for sure - but fortunately, you don't really have to know. By adeptly using options, you can both fully protect your existing profits if the bull stumbles, and play for more if it charges ahead in the New Year.

And, thanks to a holiday-related drop in market volatility over the past couple of weeks, you can do so at a very reasonable price. To verify that, you need only look at the Chicago Board Option Exchange's (CBOE) S&P 500 Volatility Index (VIX), which closed Dec. 23 at 15.45 - its lowest level since just before the market's top last April.

Normally, when one thinks of using options to lock in profits, the strategy that comes to mind is the purchase of a protective put, which will pay off should the price of the underlying asset fall sharply. However, a better approach - given current market conditions, volatility levels, and the time of year - is an outright call option "substitution."

It's a very simple strategy: You merely sell the stock on which you have profits you want to protect and buy an equivalent number of at-the-money call options on the same stock - at the money meaning the striking prices of the options are the ones closest to the actual trading price of the underlying security.

Here's an example.

Let's say you purchased 500 shares of CenturyLink, Inc. (NYSE: CTL) last July, shortly after it bounced off its 52-week low in sync with the broader market. You paid $33.50 per share, then watched the stock ride the autumn rally higher to a close of $46.40 on Dec. 27 (collecting a couple of healthy 72.5-cent-a-share quarterly dividends along the way). You thus have a profit on the CTL stock of $12.90 per share (or $6,450 on the full position) - a profit you're worried about losing should the market correct early in the New Year.

Here's how you could use a call option substitution to protect yourself, while saving the opportunity to add more gains should the stock price continue to rise.

You would simply sell your 500 shares of CTL stock, but maintain your long bullish stance by "substituting" the purchase of five at-the-money CTL February $46.00 call options (each call option controls 100 shares of CTL stock). The key features of the play are:

•By selling 500 shares of CTL at $46.40, you free up $23,200 ($46.40 x 500 = $23,200) in cash that you can use for other purposes (a benefit you wouldn't get with the purchase of a protective put).
•You capture the $6,450 in profit you currently have, ensuring you'll never give it back - no matter what the market or stock price does.
•With the February $46.00 calls carrying a premium of $1.40 (as they did on Dec. 28), you'd pay $700 ($1.40 x 100 x 5 = $700) of your profit to buy them and thus maintain your long position by controlling 500 shares of CTL stock.
•If the market does correct and CenturyLink stock falls back below $46.00 a share, you lose the $700 you paid for the calls - but that's all. You can't lose more, no matter what happens. (Note: If you dislike the notion of losing the $700 in call premiums should the stock pull back, simply think of it as equivalent to putting in a stop-loss order on CTL at a price of $45.00 per share. If you simply held the stock with that stop - a very tight one by usual standards - you'd lose the same $700 from current prices if it were triggered.)

•If the market doesn't correct, you begin adding to your already locked-in profits as soon as CTL stock moves higher. Because the $46.00 calls are already in the money, the premium will increase steadily - though initially not on a cent-for-cent basis - as the stock price rises. And, if you hold the calls until the expiration date - Feb. 18, 2011 in this instance - you'll capture additional dollar-for-dollar profits at any CTL stock price above $47.40 (the $46.00 striking price plus the $1.40 premium paid).
•Because CTL will report its fourth-quarter results before the options expire, you'll have full opportunity to capture any bounce in the stock price as a result of a positive surprise. But again, you can't lose the gains you already have should earnings disappoint.
•Should CTL stock trade relatively flat in January and early February, staying above $46.00 a share, you can re-examine the prospects for the company and, if you like them, exercise the call options. That would let you repurchase the actual stock in time to collect the next 72.5-cent quarterly dividend, adding another $362.50 to your gains on the 500 shares.
•Since it will most likely be the first week of January 2011 before you can execute this trade, you won't have to pay taxes on the stock profits you take for up to 15 months, giving you plenty of time to offset them.
This strategy will work for any long position on which you currently have profits (so long as options are traded on the stock), locking in your gains but letting you play for any continued advance.

Do be careful in choosing the expiration date of the call options you substitute, making sure they extend far enough out to benefit from the next quarterly earnings report and, if the dividend is worth considering, in ample time to qualify for that payout.

Source : http://moneymorning.com/2010/12/30/...

Money Morning/The Money Map Report

©2010 Monument Street Publishing. All Rights Reserved. Protected by copyright laws of the United States and international treaties. Any reproduction, copying, or redistribution (electronic or otherwise, including on the world wide web), of content from this website, in whole or in part, is strictly prohibited without the express written permission of Monument Street Publishing. 105 West Monument Street, Baltimore MD 21201, Email: customerservice@moneymorning.com

Disclaimer: Nothing published by Money Morning should be considered personalized investment advice. Although our employees may answer your general customer service questions, they are not licensed under securities laws to address your particular investment situation. No communication by our employees to you should be deemed as personalized investent advice. We expressly forbid our writers from having a financial interest in any security recommended to our readers. All of our employees and agents must wait 24 hours after on-line publication, or 72 hours after the mailing of printed-only publication prior to following an initial recommendation. Any investments recommended by Money Morning should be made only after consulting with your investment advisor and only after reviewing the prospectus or financial statements of the company.

Money Morning Archive

© 2005-2017 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Post Comment

Only logged in users are allowed to post comments. Register/ Log in

Catching a Falling Financial Knife